Staff in risk management, valuation, and internal audit can read this case when they check how a hedge's purpose is documented, how positions are valued, how breaches of limits are handled, and how information is passed to the regulator.

What happened

The Chief Investment Office (CIO) of the US bank JPMorgan Chase is the unit that invests the bank's excess deposits (about USD 350 billion). Through its trading in credit derivatives, the CIO's Synthetic Credit Portfolio (SCP) lost at least USD 6.2 billion in 2012. The trades are called the "London Whale" trades because they were carried out by a trader in the London office1.

The SCP's net notional size (its notional amount, net) grew from USD 4 billion to USD 51 billion in 2011, and to USD 157 billion in the first quarter of 2012. The trading centered on CDS indices, and in March the positions were as follows23.

Index Position in March
US investment-grade credit index At least USD 62 billion
European investment-grade index USD 71 billion
US below-investment-grade index USD 22 billion

The bank told the Senate Permanent Subcommittee on Investigations (the subcommittee) that the SCP was meant as insurance against the credit risk the bank held, that is, a hedge4.

Timeline

Time Event
2011 The SCP's net notional size grew from USD 4 billion to USD 51 billion2
December 2011 JPMorgan Chase instructed the CIO to reduce its risk-weighted assets2
January to March 2012 The net notional size grew from USD 51 billion to USD 157 billion2
End of March 2012 The SCP's loss at the end of the first quarter was about USD 719 million2
March 23 The head of the CIO told the SCP trader to stop trading5
April 6 Press reports drew attention to the trades5
May 10 In its quarterly report (Form 10-Q) for the first quarter, the bank disclosed that the SCP had lost USD 2 billion and might lose more6
End of June The SCP's loss reached USD 4.4 billion5
July 13 The bank restated its first-quarter earnings, adding USD 660 million to the SCP's losses7
End of 2012 The SCP's loss reached at least USD 6.2 billion5
January 14, 2013 The Office of the Comptroller of the Currency (OCC) issued a Cease and Desist Order against the bank8
March 15, 2013 The Senate Permanent Subcommittee on Investigations held a hearing and released its report9
September 19, 2013 The Board of Governors of the Federal Reserve System (FRB) announced a USD 200 million penalty10

Problems the report raised

The Overview of the Senate subcommittee's report lists what the investigation found under five headings. Four of them are the purpose of the trades, valuation, breaches of limits, and the information given to the regulator. The fifth is misinforming investors, regulators, and the public11.

The first point is the purpose of the trades. The bank said that the SCP was not a proprietary trading desk but a hedge. After the bank told the CIO in December 2011 to reduce its risk-weighted assets, the CIO adopted a strategy in January 2012 of adding long credit derivative positions, instead of selling assets. The aim was to offset its existing short positions. A long position is a bet that the value of the index will rise, and a short position is a bet that it will fall3. Adding a position in the opposite direction makes the net position smaller. As a result, however, the SCP became net long and lost the protection of the original hedge. For five years, the bank could not provide documents showing how it had set the SCP's hedging purpose, the assets covered, and the size4.

The second point is mark-to-market valuation. In early January, the CIO valued credit derivatives at prices close to the midpoint between the bid and the ask. From partway through the first quarter of 2012, it began to choose more favorable prices within the bid-ask spread. The CIO's valuations differed from those of the bank's investment bank, which led to collateral disputes with counterparties. In May, the bank told the CIO to value positions in the same way as the investment bank12.

The report also shows how large the valuation gap was. In an internal memo dated May 10, the bank's Controller accepted the USD 719 million loss that the CIO had reported, but the loss would have been USD 1.2 billion if valued at the midpoint. The report uses this gap as an example of how subjective the valuation of credit derivatives can be. On July 13, the bank restated its first-quarter earnings and added USD 660 million to the SCP's losses12.

The third point is risk limits and VaR. The CIO set limits on several risk metrics. The SCP breached the limits on all five metrics in the first quarter of 2012. Many of the breaches were largely ignored or ended by raising the limit. The new VaR model that the CIO adopted in January was withdrawn on May 10, when the bank judged it to be inaccurate, and the previous model was reinstated13.

The fourth point is the limited information given to the regulator. The OCC told the subcommittee that the first explicit mention of the SCP in the materials it received was in a routine VaR report on January 27, 2012, and that it had conducted no reviews of the SCP before then. The bank also had not told the OCC that the SCP's notional amount had grown about tenfold in 2011. The bank did report limit breaches to the OCC in its routine risk reports, but the OCC did not follow up with questions. The report says that both the bank and the OCC bear fault for the OCC's lack of awareness of the SCP14.

What changed afterward

On January 14, 2013, the OCC issued a Cease and Desist Order against the bank. Together with six Supervisory Letters issued in 2012, it set out 20 "Matters Requiring Attention"8. The FRB also issued a Cease and Desist Order on January 14 and announced a USD 200 million penalty on September 19. Together with the OCC, the Securities and Exchange Commission, and the UK Financial Conduct Authority (FCA), the total was about USD 920 million. The penalty order cites the bank's failure to adequately inform its board of directors and the FRB of risk management deficiencies that management had identified10.

The subcommittee's report lists the following seven recommendations to regulators15.

  • Reporting operating data on those of a bank's investment portfolios, including derivatives, whose notional amount exceeds a certain level
  • Documenting hedges (what is hedged and how effectiveness is checked)
  • Strengthening valuation procedures for credit derivatives
  • Investigating large breaches of limits
  • Investigating models that greatly reduce risk
  • Finalizing the Volcker Rule
  • Adding a capital charge for derivatives trading

The current content of the Volcker Rule is covered in The Volcker Rule.

Notes

  1. Report of the Senate Permanent Subcommittee on Investigations (included in Volume 1 of S. Hrg. 113-96; "the subcommittee's report" below), p. 1 (PDF page 170). ↩

  2. The subcommittee's report, pp. 5–6 (PDF pages 174–175). ↩ ↩2 ↩3 ↩4 ↩5

  3. The subcommittee's report, p. 39 (PDF page 208). ↩ ↩2

  4. The subcommittee's report, pp. 5–6 (PDF pages 174–175). ↩ ↩2

  5. The subcommittee's report, p. 6 (PDF page 175) and pp. 12 and 14 (PDF pages 181 and 183). ↩ ↩2 ↩3 ↩4

  6. The subcommittee's report, p. 14 (PDF page 183). ↩

  7. The subcommittee's report, p. 9 (PDF page 178). ↩

  8. The subcommittee's report, p. 13 (PDF page 182). ↩ ↩2

  9. Cover of Volume 1 of S. Hrg. 113-96 and its table of contents (PDF page 13), on the release of the report in conjunction with the hearing. ↩

  10. Federal Reserve Board, "JPMorgan Chase & Co. to pay $200 million for oversight, management, and controls deficiencies" (September 19, 2013), text (the penalty amount, the total with the other agencies, and the reasons the order cites). ↩ ↩2

  11. The subcommittee's report, pp. 5–14 (PDF pages 174–183), Overview (B. Overview), headings (1) to (5). ↩

  12. The subcommittee's report, pp. 6–9 (PDF pages 175–178). ↩ ↩2

  13. The subcommittee's report, pp. 9–10 (PDF pages 178–179). ↩

  14. The subcommittee's report, pp. 11–12 (PDF pages 180–181). ↩

  15. The subcommittee's report, pp. 21–22 (PDF pages 190–191), "E. Recommendations". ↩